Is There Any More Juice Left In The Junk Bond Market?

| About: SPDR Bloomberg (JNK)
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More and more investors have been attracted to the junk bond market as the bank interest rates are artificially low and the yields on the Treasuries trails inflation. SPDR Barclays Capital High Yield Bond ETF JNK, which tracks the widely followed Barclays Capital High Yield Very Liquid Index, has seen its cash inflow of almost $5 billion since the beginning of 2010.

Amid a continued drop in dividend payout, some financial experts warn there may be bubbles in the junk bond market. One of the arguments that buttresses the claim is that the yield spreads have dropped so dramatically that current returns won't be able to justify the risks investors take in the junk bond market. Before we jump to any conclusions, let's do a reality check.

The most recent recession forced the Fed to lower the interest rate and keep it low for a few years. The ultra low interest rate has given bond issuers more breathing room. New issues can bear lower dividends given the same or lower yield spreads. Even worse, issuers can also repay the callable bonds, pushing investors into lower yield issues. On the credit risk front, the overall default rate of junk bonds has dropped from the peak in 2009 so much so that bond issuers deem the decrease in dividend payout is in line with credit market conditions.

The following chart has shown that the dividend for JNK dropped by 42% in 36 months.

Chart Source: Zumlon Technologies LLC

The yield has almost shrunk 45% since October of 2009 as unabated enthusiasm kept supporting the price in spite of the continuous drop in dividends throughout the 36 month period.

Chart Source: Zumlon Technologies LLC

More prominently, the yield spread between JNK and 10 year T-Note has decreased from 880 bps in October of 2009 to 502 bps in September of 2012.

Chart Source: Zumlon Technologies LLC

One of the reasons behind this is that the overall default rate for the high yield bond market has steadily improved since mid 2009. The diminishing yield spread mirrors the change. In the summer of 2009, the HY default rate topped out at 14%. Now it stands around 3%. Today, owning the JNK ETF may have lower risk than doing it in 2009. The yield spread is still above the default rate plus some premiums.

On the other hand, the current low yield environment may continue to disappoint income-hungry investors. From the top 10 holdings of JNK, we found most of the issues are double B or single B rated by Moody's. In order to enhance the yield, investors have to sacrifice quality of issues. By moving down aggressively to single B and even highly speculative C issues, the yield will be raised so long as investors stand ready to face the default risks.

Bond Issuer Sector Type Detail Moody's S&P
US852061AK63 Sprint Nextel Corporation Telecom Senior Debt 9% Guaranteed senior unsecured notes, due Nov 15, 2018 BA3 BB-
US404121AC95 HCA, Inc. Health Care Senior Debt 6.50% Senior secured notes due Feb 15, 2020 BA3 BB
US319963BB96 First Data Industrial Senior Debt 12.62% Senior unsecured notes, due Jan 15, 2021 CAA1 B-
US29269QAA58 ENERGY FUTURE/EFIH FINAN Utility Senior Debt 10% Senior secured notes, due Dec 1, 2020 CAA3 B-
US796038AA56 Samson Investment Co Oil & Gas Services Senior Debt 9.75% Senior notes due Feb 15, 2020 B1 B-
US413627BL36 CAESARS ENTERTAINMENT OPERATING CO Consumer Services Senior Debt 8.71% Senior notes due Jun 1, 2017 B3 B
US451102AH03 ICAHN ENTERPRISES/FIN Financial Senior Debt 8% Senior unsecured notes due Jan 15, 2018 Ba3 BBB-
US12543DAL47 CHS/COMMUNITY HEALTH SYS IN Health Care Senior Debt 8% Senior unsecured notes due Nov 15, 2019 B2 B
US29977HAA86 EP ENERGY/EP FINANCE INC Industrial Senior Debt 9.375% Senior unsecured notes due May 1, 2020 B2 B
US676253AC15 OFFSHORE GROUP INVST LTD Financial Senior Debt 11.5% Senior secured notes due Aug 1, 2015 B3 B-

Data Source: Zumlon Technologies LLC

However, what investors really should do is to look forward to future default rates among issues. Unfortunately, that does not bode well as recent overall HY default rate has begun to edge up near the standard threshold of 4%. Our model has detected some unnerving upward pressure of the overall default rate and expects the rise may continue.

As a predictive indicator, if it keeps on marching northwards, another recession may be looming. Current investors may still be able to load junk bond issues, but the exit strategies have to be well planned ahead.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.